Reserve Board Cuts Key Rate; Markets Climb

By DAVID E. SANGER

Published: December 20, 1995

WASHINGTON, Dec. 19—
Nudged along by a slowing economy and nervous financial markets, the Federal Reserve lowered a key interest rate today by a quarter of a point.

The cut in short-term rates, which the Federal Reserve said was justified because of the lack of any threat of inflation, allowed the stock and bond markets to regain some of their big losses on Monday. But it left considerable uncertainty about whether Wall Street would be cheered by President Clinton's agreement with Republican Congressional leaders this afternoon to come up with a framework for a budget accord that would be concluded by the end of the year. The announcement at the White House came after the markets closed.

The Federal Reserve action, trimming to 5.5 percent the rate at which banks lend each other money overnight, marked the first time in five months that the nation's central bank has yielded to the perception in financial markets that interest rates were too high. [Page D1.]

But in a quirk of the interplay among the Federal Reserve, the markets and the budget negotiators, the small cut in interest rates and the resulting 34.68-point increase in the Dow Jones industrial average may actually ease some of the pressure for a quick compromise on a balanced budget.

The sharp drop in the financial markets on Monday provoked considerable finger-pointing in Washington this morning. Fear spread among politicians in both parties that they might be blamed for reversing the huge run-up in the stock and bond markets over the year. But it was unclear how big a role those fears played in the agreement reached this afternoon among President Clinton, House Speaker Newt Gingrich and Senator Bob Dole, the majority leader, to try once again to settle their differences -- this time by the end of next week.

"A hundred-point drop is not big enough to force anyone to make concessions they view as unwise," one senior Administration official said today. "But it certainly is big enough to get your attention."

Consumers are likely to derive only limited benefits from today's cut. The Federal Reserve left unchanged at 5.25 percent the discount rate, which it charges banks for short-term loans. Only one bank, Banc One of Columbus, Ohio, responded to the Fed's action today by cutting its prime lending rate, which helps determine the rate on a variety of consumer and small business loans. Others may follow soon. Markets also drove down longer-term rates that influence the cost of home mortgages, but they remained above levels prevailing earlier this month and any savings to consumers would be modest.

In Washington, though, symbolism is often more important than substance, and the symbol of a rate cut at a time of a Government shutdown and a possible budget deal is a particularly strong one. The Fed's chairman, Alan Greenspan, has waded into the middle of the balanced-budget debate several times, predicting to Congress that a balanced budget accord would prompt the markets to cut long-term rates even further. Several analysts viewed the Fed's rate cut as a carrot dangled in front of White House and Congressional leaders as the nation moved into a critical election year.

To no one's surprise, Mr. Greenspan mentioned none of the political maneuvering on the budget in his terse statement announcing the Fed's cut in rates. "Since the last easing of monetary policy in July," he said, "inflation has been somewhat more favorable than anticipated, and this result along with an associated moderation in inflation expectations warrants a modest easing in monetary conditions."

While the Federal Reserve was concerned about some indicators of a slowing economy -- weaker retail and auto sales, an erratic housing market and some signs that the worldwide demand for semiconductors is winding down after a frenetic year -- it clearly does not view a recession as a real danger. Economic growth, in fact, was not even mentioned in Mr. Greenspan's statement.

What gave the Fed a bit of room to operate was the low inflation rate. Curbing inflation is the Fed's chief mission, and with the Consumer Price Index rising only 2.6 percent so far this year, the rate-setting Federal Open Market Committee could initiate a modest reduction without any fear of adding any fuel to the inflationary embers.

No sooner had the Fed acted today than the Secretary of the Treasury, Robert E. Rubin, declared that the economy was in fine shape. "We believe that the current expansion has considerable room to run," Mr. Rubin said in a statement that was released jointly with Joseph E. Stiglitz, the chairman of the White House Council of Economic Advisers.

But privately, Mr. Rubin has been warning Administration officials that the markets have built into their current high levels the assumption that a balanced budget deal will be reached. And his warning was borne out on Monday, when the specter of budget impasse was enough to touch off a correction that seemed simply waiting for an excuse to set it off.

The unresolved question is whether the slightly better prospect of a budget deal will be enough to sustain the rebound that began this afternoon. While the Fed's cut buoyed the market, that move is not likely to be repeated soon. As one White House aide put it late today: "Next week Alan Greenspan isn't going to be able to put his finger in the dike."

The Federal Reserve will not meet to consider interest rates again until the end of January, and it is unlikely to act any earlier unless economic conditions change markedly..

So the markets may be riding out the end of the year on the ups and downs of the budget talks, at once reflecting their progress and influencing their outcome. It is a situation that leaves many analysts and fund managers uneasy.

"When you look at the effect the budgets they are talking about have on the economy, it doesn't amount to a hill of beans," said Allen Sinai, the chief global economist at Lehman Brothers. The shrinking of the Federal budget, Mr. Sinai has calculated, could cause a $20 billion to $25 billion "drag" on economic growth next year. In a $7 trillion economy that rolls ahead as relentlessly as the Mississipi River, that is a small drop in the stream.

One crucial piece of information that the Federal Reserve is supposed to rely on -- the latest estimate of growth of the gross domestic product for the third quarter -- may not have been available to its policy makers today. That is because of the continuing shutdown of many corners of the Government, including the Commerce Department, which compiles the statistic. It will not be released publicly until a continuing budget resolution is passed, allowing the department to reopen.

The Federal Reserve's action today concludes a year in which it received an enormous amount of scrutiny for doing relatively little to interest rates. The last change in the Federal funds rate came in July, when the Fed lowered it by a quarter of a percentage point to 5.75 percent. Just as it did today, the Fed left the discount rate unchanged at 5.25 percent.

Seven increases during the 12-month period beginning on Feb. 4, 1994, pushed the Federal funds rate up to 6 percent from 3 percent. The Federal Reserve Board also raised the discount rate in four stages, to 5.25 percent from 3 percent, beginning on May 17, 1994.